Product Markets Offer New Evidence on How Board Structure Affects Firm Performance

In a new paper, we discuss our findings on how corporate board structure affects firm performance under different product market conditions. Though many studies have examined the relationship between corporate board structure and firm performance, some have found that board independence has a positive effect on performance while others have found that it has a negative effect and still others have found a statistically insignificant correlation. More recent studies, though, have taken a new perspective, examining whether the association between board independence and firm performance depends on product market demands.

Changing product market conditions can affect the need for monitoring by outside directors. For example, the deterioration of product market conditions may lead to lower profits and thus weaken a manager’s incentive to work hard, because there is less upside to reducing production costs or increasing product demand. This suggests that outside board members play a more significant role in a difficult product market. However, adverse product market conditions may substitute for outside director monitoring by prompting managers to perform better just to survive. Hence, how product market conditions influence the need for monitoring remains an empirical question. In addition to monitoring, outside directors also have advisory roles. In the event of product market disruptions, firms may face difficult corporate decisions and more financial constraints. Expert advice from outside directors may help firms recover from adverse shocks in the supply chain by offering management and financing expertise.

Empirical work provides evidence that board independence is positively associated with firm performance after a negative downstream-demand shock. One standard deviation (about 14 percent) increase in board independence, based on the proportion of outside directors on the board, is associated with a 0.8 percent increase in return on assets (ROA) after such a shock.

Consider a firm with nine board members, seven of whom are outsider directors. Replacing one inside director with an outside board member would be associated with a 0.6 percentage-point increase in ROA when the firm faces an adverse demand shock. The magnitude of the increase is considerable, approximately 29 percent of the total ROA for an average firm.

Companies in the same industry can be subject to different product demand conditions, while firms in different industries can face the same demand conditions. The idea is that a firm faces an exogenous demand shock when its customers’ downstream demand falls. In such dire business conditions, increasing board independence can help improve performance. Such a shift in board structure may lead up to a 3 percent increase in Return on Equity (ROE) and a 1.2 percent increase in sales growth.

In fact, adverse business conditions may amplify the benefits of an independent board. Research shows that the positive effect of board independence in bad times is stronger when a firm is small, experiences a high growth rate, and operates with high risk, all of which are related to a more constrained environment. In such an environment, valuable guidance by outside directors can improve financial performance of the firm and increase earnings from operations.

The board has two main functions: monitoring and advising. Independent directors monitor management give advice on operations, policies, and related business decisions. Empirical evidence suggests that it is the board’s monitoring function rather than advisory function that drives the effectiveness of board independence in bad times.  Board independence improves firm performance most when the firm’s CEO is entrenched and there is no CEO turnover for at least 15 years. Board independence also has a positive effect in firms with high free-cash flows. Both issues are related to serious agency problem that can be mitigated by strong monitoring from independent board. As for a board’s advisory role, using the strength of outside directors’ connection to customers’ industries as a proxy, research shows that informed advice cannot explain the performance improvement associated with higher board independence in bad times.

Improving board independence by hiring outside directors can benefit firms, especially when product market conditions deteriorate, because it can prompt companies to act more aggressively when hit with a negative shock.

This post comes to us from Professor Onur K. Tosun at the University of Warwick’s Warwick Business School, Dr. Xiaoyuan Hu at Cornerstone Research, and Professor Danmo Lin at the Warwick Business School. It is based on their recent paper, “The Effect of Board Structure on Firm Performance – New Evidence from Product Market Conditions,” available here.